For most of the past five years, gains in the stock market have been fueled by P/E expansion in an interest-rate-driven market. While we're unlikely to see much more P/E expansion at this point of the cycle, this bull market may not be on its last leg. Earnings growth — a factor as powerful as declining interest rates have been thus far — could emerge as the new force to drive the market higher.

As interest rates fall, stock prices rise relative to earnings

During P/E expansion cycles like the one that may be ending now, equity prices rise in proportion to earnings. Historically, prices have increased by more than 50% on average during a cycle. Since 2011, the P/E multiple on the S&P 500 has increased from 10x to 18x, and in doing so, has made this cycle one of the most powerful in history.

Long expansions can lead to sharp corrections

In the most recent half-century, when cycles have stretched any longer than our current one, they have generally ended poorly for investors. For example, the bear market in the first few years of this century resulted from the 1999 Tech Bubble popping, which came at the climax of a P/E expansion cycle even more robust than today's. Similarly, the 1987 market crash can be traced to a large run-up in P/E multiples ahead of the Black Monday collapse.

New earnings growth can extend a cycle

As the current P/E expansion cycle appears to be stalling, earnings growth is necessary to prolong the bull market and avoid a fate comparable to those mentioned above. Equity prices will likely depend on improvements in corporate earnings to advance from recent levels.

The potential for rate increases raises the stakes for companies to deliver earnings

The Federal Open Market Committee (FOMC) debated raising interest rates at its September meeting, and there is a growing likelihood for interest-rate hikes going forward. With P/E multiples expected to contract as rates rise, the prospect of a rising-rate environment makes earnings growth all the more critical for sustaining the current bull market.

Recent profit recession and market pullback may set the stage for better growth ahead

Will the looming earnings environment be enough to sustain the market in the face of P/E contraction? Historically, earnings-driven bull markets have occurred in the year following an earnings trough. The encouraging news for investors is that after four straight quarters of earnings decline amid a profit recession, some acceleration is expected, as indicated by the chart. In the past, while multiples have typically contracted prior to an earnings resurgence, the market has historically advanced by double digits when companies deliver new earnings growth.

As we enter the home stretch of 2016, earnings could be the factor that determines whether this bull market catches a second wind or falls to its knees.

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